Active managers seek to outperform the stock market by picking companies in which they see the inherent potential that other market participants may have missed. There are many styles of active asset management – from growth to value to sector specialists – but their objective is the same. Can the return of an active fund consistently exceed that of not only other managers but also the passive return of the market index?

Broadly speaking, stock-picking active managers tend to select investments based on conditions of “size” and “value”. Size means favouring smaller companies over bigger ones, which is based on the famous “small firm effect”, a theory that smaller companies tend to grow faster as it is harder for already massive companies to get ever more gargantuan.

Similarly, “value” is a critical concept for those managers who attempt to find “alpha”, or the outperformance of a portfolio versus the “beta”, or general market risk premium. To beat the market, managers should find companies with greater embedded potential than the market has priced in. Therefore, when this ability to generate higher earnings than expected becomes broadly evident, its stock multiple “rerates” (theoretically only after the cunning active manager has invested in it), and it increases in price.

Of late, for reasons that are still unclear, almost precisely the opposite has transpired. An overwhelming majority of the performance in global stock markets over the past 10 years has come from massive global companies – many tech-related – becoming ever larger. They consistently defy active managers’ claims (many of whom have regarded them as overvalued), trading on multiples far removed from reality. From Netflix to Amazon, they have simply become bigger.

Explanations for this range from the macro (usually related to the exceptionally easy monetary policies that have created tsunamis of liquidity) to the micro (for example, changing economic structural conditions such as extremely profitable tech monsters).

The implication has been clear: passive has smashed active. Cumulatively, since 2010, more than $4-trillion has gone into passive managers while active have bled around $2-trillion, according to research by EPFR Global. There is now over $12-trillion in passive managers globally, which moves up and down in line with the index, and costs a lot less in management fees.

This is unsurprising when one considers performance. According to research by S&P, under 20% of global equity active managers have beaten the passive index benchmark over the past 15 years, even before their higher fees have been taken into account. Active stock market management, when confronted by the data, simply looks like an enormous industry of snake oil-selling charlatans.

However, active managers have argued that they have been waiting for the next downturn and the unwinding of these insane momentum-based valuations. They may finally be right. The stock market’s downward re-ratings of the past two months have been brutal and may indicate that the active managers’ logic is starting to prevail.

Among the consensus growth names, Paypal has decreased in market capitalisation from $350-billion to $150-billion, Salesforce from $300-billion to $200-billion, Adobe from $320-billion to $220-billion, and computer chip specialist ASML from $350-billion to $250-billion. In total, that is around $500-billion of market capitalisation being incinerated in stocks that active managers may not participate in as much.

Who knows whether the tide will once again turn back to simply buying the market and hoping for the best, or whether this will now be a golden period of stock pickers as the senseless valuations of the past 10 years start to unravel? However, investors would do well to be aware of the various merits and pitfalls of both approaches. DM168

This story first appeared in our weekly Daily Maverick 168 newspaper which is available for R25 at Pick n Pay, Exclusive Books and airport bookstores. For your nearest stockist, please click here.